Anne Quincy took the short side of a forward contract on the S&P 500 Index three months ago in an attempt to hedge short-term changes in her index portfolio.
The contract had a term of six months at the purchase date, a contract price of $ 1,221 and Mason Inc. as the counterparty. Quincy is now considering unwinding her short position using either a three-month Mason Inc. contract with a price of $1,220, a three-month JonesCo contract with a price of S1,219, or a three-month
Redding Company contract with a price of $1,218. If Quincy wants to minimize credit risk, which of the following should she do? Take the long position in the contract with:
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A. B. C.B
To minimize credit risk, Anne Quincy should take the long position in the contract with Mason Inc. (Option B).
Credit risk refers to the risk that the counterparty in a financial transaction may default on their obligations, resulting in financial loss to the other party. In this case, Mason Inc. is the counterparty with whom Anne Quincy entered into the original forward contract on the S&P 500 Index.
When considering unwinding her short position, Anne Quincy has three options: a three-month contract with Mason Inc., a three-month contract with JonesCo, and a three-month contract with Redding Company. The prices of these contracts are $1,220, $1,219, and $1,218, respectively.
To minimize credit risk, Anne Quincy should choose the counterparty with the highest creditworthiness and lowest probability of default. In this case, Mason Inc., the counterparty from the original forward contract, has already demonstrated its creditworthiness by entering into the initial agreement. Therefore, it is likely to be the safest choice.
Comparatively, JonesCo and Redding Company are new counterparties and do not have an established track record of creditworthiness in this context. Consequently, they carry a higher level of credit risk compared to Mason Inc.
Therefore, Anne Quincy should choose to take the long position in the three-month contract with Mason Inc. (Option B) to minimize credit risk.